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You Think You Understand Network

E4ects, but You Probably Don’t


Lessons from Blue Apron, Uber, Amazon, and Facebook on how
businesses really build competitive advantages

Matt Ward
Apr 5, 2018 · 9 min read

Photo by Barth Bailey on Unsplash

Remember the beach? It was always a battle to build the best sandcastle. But
inevitably, the tides turned and waves washed away your creation… you were
devastated.
I hope you learned your lesson.

Moats are the most important aspect of any business. A defensible moat is the
di?erence between lasting value and proAtability and being ripped apart by the
waves (i.e. competitors).

And while every entrepreneur “knows” they are building an unbreakable moat, is
that really the case?

Moats
Rats run towards food, founders Gock to money. Large opportunities lead to Aerce
competition — and nothing ruins venture returns quite like competition.

There is a saying among investors:

“Being ‘right’ doesn’t lead to superior


performance if the consensus forecast is also
right.” — Bill Gurley
Consensus never pays.

Competition catches on to obvious ideas (hence the issues with Uber’s business
model).

Uber built a business around the “idea” of a moat. Because of local network e?ects
between riders and drivers, Uber was able to build incredibly strong local networks
— and to raise over $22B to fund their expansion.

I won’t dig into the issues with Uber’s model/assumptions again, but instead, I want
to use their “moat” as an entry into the various moats most businesses employ.

So, how do you keep competitors at bay?

Many, Many Moats


In business, there are many ways to stand out. And what is defensibility if not a
reason to choose one brand over another, or to remain a customer?

A moat either traps customers on your island or


makes your castle an attractive destination… both
acquisition and retention drive revenue.
It boils down to: What is your unique competitive advantage?

Without that, you don’t have a business. With that, you may have an empire…

Broadly speaking, there are seven customer acquisition and three customer retention
moats that power the vast majority of businesses.

The best businesses build barriers for both.

Acquisition moats:
1. Brand

2. Network e?ects

3. Product

4. Patents and/or proprietary products

5. Licenses

6. Distribution

7. Pricing power

Retention moats:
1. Brand

2. Network e?ects

3. Switching costs
. . .

Understanding Moats
Acquiring customers is sexy. People prefer increasing revenue to cutting costs — it is
our shortsighted, ego-driven nature. In venture especially, revenue is king. If we can
acquire customers and make money, we will Agure out the economics eventually.
Raise round after round until you Agure out proAtability, right?

Of our acquisition advantages, I’d argue all but network e?ects are pretty well
understood.

You know why you buy Apple (brand), use Comcast (no choice), prefer NetGix (great
product) or get the best deals on Amazon (price + selection)… acquisition is
relatively easy to understand.

The biggest misconception is with network e?ects, speciAcally with anticipating


them.

The same is true for retention. It is a nightmare to change your bank and you’ve
always voted Democrat (brand) so why switch things up? If it ain’t broke, don’t Ax it.

. . .

The Nuances of Network E>ects


Nothing trumps network e?ects. Businesses without strong network e?ects (NFx)
always struggle, both in terms of growth and proAtability.

Thanks to business basics and GAFA’s chokehold on the economy (and on our
attention), we all have at least a basic understanding of network e?ects.

The problem is, by assuming we understand and can anticipate network e?ects,
many entrepreneurs set themselves up for failure.

. . .
6 Misconceptions About Network E>orts
1. Word of mouth ≠ network e>ects
Telling friends about Facebook improves your experience; the same isn’t true for
Starbucks. At best, Starbucks gets more business. At worst, I’m stuck behind more
co?ee crazed addicts waiting for a Ax.

Word of mouth is a powerful tool, but by itself does not constitute a network e?ect.

2. Incentivized referrals ≠ network e>ects


The same holds here. Incentivization is a great acquisition strategy but not a
defensible, product enhancing network e?ect in the majority of instances
(cryptocurrencies excluded).

3. Data ≠ network e>ects


Data alone doesn’t deAne a network e?ect. While data is incredibly valuable to
understanding and inGuencing customer behavior, it only becomes a product
improving network e?ect once you learn to e?ectively utilize it. Plenty of companies
capture mountains of data — they just don’t know what to do with it. Insights are
valuable, noise isn’t.

4. Law of diminishing returns still applies


Network e?ects never die, but the resulting impact on overall defensibly and product
has diminishing returns. The two-billionth person on Facebook did little to improve
either social graph connectivity or user behavior patterning.

Network e?ects, like everything else, operate in an S curve — the question is, how
high is the ceiling?

5. Not all network e>ects are international


Case in point, Uber. Uber’s product improves as local usage increases, but NYC
having more drivers and riders does approximately nothing for my experience in
Zurich. That means local networks are secure, but also frail. Competitors can enter
any individual market, outspend incumbents and claw their way to the top.
In the situation of Uber, because any city or country can create competitors and any
fool (or fund) can fund those upstarts, the competition tends towards inAnity. What
happens when supply exceeds demand?

6. Scale decreases CAC, i.e. improves economics


See below.

. . .

Blue Apron’s Big Problem


We mentioned Uber, but Blue Apron is a more interesting example.

Founded in 2012, Blue Apron pioneered the subscription meal kit. Get all the
ingredients for an at-home, Ave-star meal — no worry, no hassle.

The value prop was obvious: easy, convenient, healthy, home-cooked, tasty meals.
What family wouldn’t want that? And even though the price was a bit high, Blue
Apron targeted the upper-middle-class anyway — it is a health food thing.

Growth was spectacular, it just took o?.


And investors ate it up, literally. To date, the company has raised just south of $200M
(excluding IPO).

On June 1st, 2017 Blue Apron Aled for IPO. They were looking to raise $500M from
public investors to further growth of the company and hit scale. Interestingly, their
unit economics were still a bit shaky. But that was okay; plenty of companies had
gone public prior to hitting proAtability. As long as you were moving towards
proAtable, everything was on track.

Unfortunately, Blue Apron’s acquisition costs and business model were built around
a relatively long payback period and anticipated a decreased CAC (cost of customer
acquisition) because of course network e?ects would spread the service (via word of
mouth, etc.).

It didn’t quite turn out how they planned. Instead, customers canceled at higher
rates and it became clear that between market saturation (of high-end healthy
foodies) and increased competition from other startups, Amazon, and even
supermarkets made acquiring and retaining customers much harder and more
expensive.
Blue Apron priced their IPO at $15–17 per share. The numbers speak for themselves.

Evaluating Network E>ects


In hindsight, it is obvious to see the Gaws in Blue Apron’s business model. The
network e?ects are little to non-existent and competition kills margins. There is no
advantage to me as a consumer when my friends use the service. My food isn’t better,
it isn’t cheaper, it isn’t faster… Why tell anyone about it?

“Hi, guess what… I’m cooking for my family, but kind of too lazy to do it myself…”

Someone screwed up here. And while investors made out like bandits (if they sold in
time), retail investors were left holding the bag.

The question is and will always be, how do you evaluate network e?ects?

Both as an investor and as an entrepreneur, it is critical to understand the business


model and how unit economics and CAC/LTV ratios can change over time.

In Blue Apron’s case, they were aggressive with projections. By assuming growth
equated with a decreasing CAC, and that LTV/retention would remain constant, they
set themselves up for failure. The economics could never work.

But the opposite can be equally as detrimental. This occurs most frequently with
bootstrapped startups. When startups grow purely via organic growth (or fail to
foresee improving unit economics), they can underspend and forfeit a lead. Plenty of
funded companies are willing to burn through cash to close the gap and capture the
market — slow down for a second, and you can be overtaken.

Which mistake is worse? It really depends on the market and the competition. But in
the world of venture scale returns, both can come back to bite investors — hence the
go big or go home mentality.

. . .

Numbers Never Lie


Blue Apron’s -nances were not the problem; the assumptions were. And while
eventually the assumptions are proven incorrect, this isn’t always the case in the
short term.

In the middle of the hype cycle (ie S curve), it looks like you are going to the moon.
The business is taking o?, CAC may even be decreasing due to increased exposure in
the market, and all in all, the business looks pretty damn good.

But what happens when the ceiling hits sooner than you anticipated or other factors
like competition or retention rates begin to change? Suddenly your proven
assumptions are shaky, the market reacts and your stock craters.

. . .

Productive Pessimism
I was interviewing an investor for The Syndicate podcast, and he said something
pretty profound.

“In a room full of optimists, it pays to have at least


one pessimist.”
This is important, especially as the stakes become higher. Startups are stupidly
optimistic. That is why they take on the world and the impossible and they win. But
there comes a time in any company’s lifecycle when a bit of pessimism (plus realism)
starts to become beneAcial.

If you are willing to listen to the negative Nancy, you might be able to avoid the Blue
Apron balloon. Questioning the assumptions and beliefs in their apparent network
e?ects would have saved the company a lot of headache.

Unfortunately, this is a delicate balance. Negativity neuters greatness. Pessimistic,


realistic viewpoints early on can stiGe innovation (hence why no one likes lawyers).
“Move fast and break things” is a great motto for a startup.

But you need to know when to put on the big boy pants.

. . .

Understanding Incentives
Founders and VCs both focus on enormous returns. Carry creates a scenario where
investors focus on outsized returns over all else.

This can make venture capitalist a horrible partner/pessimist. It is in the VC’s best
interest to push the envelope, and their excitement over large returns can cloud
judgment.

It is easier to tell someone they have an ugly baby on the bus than at a family
reunion. You aren’t tied together for life or even directly associated with the outcome
— in other words, you can be brutally honest without subconsciously seeing green.

. . .

First Principles
Questioning assumptions is the best way to pressure test your projections. Keep
asking why and eventually you get to the root of the question.

The best founders and investors are able to “see” the future. I’ll leave you with a little
Elon.

The First Principles Method Explained by Elon Musk

Closing Thoughts
Nothing beats Gywheel network e?ects — but nothing is harder to conceptualize,
create, and scale either.

What moats are you most excited about? How have you backed defensibility into
your business?

Investors look hard at barriers to entry. Well defended castles create kingdoms.
Those are the kind of companies our syndicate invests in. And those are the kinds of
strategies and tactics I advise startups on.

It doesn’t take genius — it takes Arst principles thinking and a hell of a lot of e?ort,
analysis, and testing.

Build your business, run like hell, but be sure you are building a moat in the process.
Snapchat sort of missed the ball here, as did Blue Apron. Both were great outcomes,
but both built on a mountain of sand.

Sandcastles have a tendency to wash away.


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